What it is:
How it works/Example:
Let's assume interest rates have come down and City XYZ wants to refinance some outstanding municipal bonds. First, City XYZ hires an underwriter (usually a department that is part of a much larger financial institution, such as an investment bank) to handle the logistics, compliance, and administrative tasks associated with the offering.
One of these tasks is called "advance refunding," whereby City XYZ invests the proceeds from the new bonds in U.S. Treasurys with the intent of using the Treasurys to pay off the old bonds sometime in the future. (Municipalities can't always pay off their bonds at will; sometimes restrictions in bond covenants mean they have to wait to actually send the checks out.) The underwriter purchases the Treasurys on behalf of City XYZ and this Treasury portfolio is now called the "escrow portfolio."
The federal government does not tax municipalities on the interest they pay on municipal bonds. But in order to make up for the lost revenue, it does limit the amount that City XYZ can earn on its portfolio of Treasurys to no more than the yield on its new municipal bonds. Given that Treasurys normally yield more than municipal bonds, this can be an issue for City XYZ and for the underwriter that is trying to get the deal done.
This is where the inverse relationship between coupon rates and bond prices comes in. In order to comply with the rule that the yield on the escrow portfolio can't exceed the yield on City XYZ's new bonds, the underwriter purchases the Treasurys on behalf of City XYZ, marks up the price wildly, and sells the Treasurys at their inflated price to City XYZ's escrow fund. Because the underwriter artificially raises the price of the bond, the yield goes down significantly. Thus, the underwriter illegally burns the yield down to a level that appears to comply with the federal law while making a substantial profit for itself.
Why it matters:
Yield burning diverts money to underwriters at the expense of the U.S. Treasury, and it jeopardizes the tax-exempt status of interest paid to holders of municipal bonds (and in some cases, the municipalities) associated with the practice. The SEC has prosecuted dozens of investment banks and financial institutions for this practice and has levied hundreds of millions of dollars in fines against them.